Tuesday, December 10, 2013

In a recent post Paul Krugman refers to the potential link between rising levels of debt prior to the 2008 crisis and the current discussion on secular stagnation. The argument can be illustrated by the chart below (borrowed from Krugman's post).

Quoting from Krugman's post:

"Debt was rising by around 2 percent of GDP annually; that's not going to happen in the future, which a naive calculation suggests a reduction in demand, other things equal, of around 2 percent of GDP"

In summary, increasing debt ratios area unsustainable and the adjustment can have a negative effect on growth. The argument is probably right but when it comes to assessing the real impact on growth I think we need to do a more careful analysis before reaching that conclusion.

Here is where I think the reading of the previous chart becomes more complicated: Why was debt going up? For some this is simply a reflection of excessive spending that directly feeds into demand. The fact that it is excessive leads to the need to reverse the trend in the years that follow and, using the same logic but now going back, it will lead to a reduction in demand. But to reach that conclusion we first need to do a more careful analysis of the balance sheet of US households by looking not only at their liabilities but also at their assets. Below is a chart of total assets (blue line) and just financial assets (red line) during the same period of time (and both measured as % of GDP).

We also observe an upward trend. How do these two trends (assets and liabilities) compare? We can measure it by looking at the difference between assets and liabilities = net wealth of US households (as % of GDP).

What we see is also an upward trend with large volatility around the last two recessions. An upward trend means that asset values are growing faster than debt. Today's net wealth is below the peak of 2005-2006 but it is above the level of any other year in the sample. With this new perspective it is more difficult to conclude that debt is still high or that it cannot grow from current levels.

What I find more interesting (and intriguing) is that rising debt (as a % of GDP) at the same time as asset values increase (even faster) is not the exception but the norm when one looks at a larger sample.

Below is the evolution of Household Debt (blue, right axis) and Net Worth (red, left axis), both as % of GDP during the 1975-1995 period. So I am excluding the last two asset price bubbles to look at a more "normal" period. We still see rising trends for both series. So debt ratios were increasing fast but asset values were growing at an even faster rate, so the net worth kept going up through those 20 years.

What these charts suggest is that the analysis of debt is a complex one and it requires a careful look at both sides of the balance sheet. And unless I am missing some relevant academic research, we do not have a good framework to think about these trends. And things can get a lot more complicated if we start adding other issues, such as the distribution of holdings of assets and liabilities. It could be that the households that are holding the assets are not be the same as the ones holding the debt, and this can change the way we think about the implications of these trends.

Antonio Fatas

I am the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, a business school with campuses in Singapore and Fontainebleau (France), a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).